Don't let it get away!

On the heels of the European debt crisis comes a deepening fear that China's boom is unsustainable. A new report from Bloomberg illustrates just how precarious China's soaring growth may be. According to its study, the debt of China's local government financing companies, used to fund the construction, may total $622 billion. That figure may not be so startling on its own, but this apparent gross underreporting is one of several reasons I'm afraid China's real estate bubble is full of hot air.

1.Ghost citiesThe Chinese government has announced plans to build 20 cities a year for the next 20 years, but they seem to be forgetting one thing: people. According to some estimates, there are already 64 million vacant apartments across the country. One recent development, Daya Bay, is designed for 12 million people, but even the state-controlled media admits that 70% of its residential units are unoccupied. China analyst Gillem Tulloch considers it the modern equivalent of building pyramids. "It doesn't really add to the betterment of lives," he said, "but it adds to the growth of GDP."

Residential real estate construction now accounts for a tenth of China's GDP compared to just 6% in the U.S. at the peak of the housing bubble in 2005, and prices have become severely inflated. The average home price in China is about nine times the mean annual income, while the historic average in the U.S. is three, and only reached 5.1 at the peak of the housing bubble. Real estate prices have now started declining, which will have an impact on everything from prices for commodities like iron, copper, cement, and coal to a slowdown in the global credit market. A UBS analyst called the Chinese real estate market "the single most important sector in the entire global economy, in terms of its impact on the rest of the world" because of the materials needed for all that construction.

2. Cooking the booksThose falling real estate prices may cause government authorities to default on their loans. The severity of the debt underreporting uncovered by the Bloomberg report can be seen on the books of the banks financing the construction. For instance, the Industrial and Commercial Bank of China, the largest of the banks, reported loans of 931 billion yuan, but the Bloomberg survey of 2% of its borrowers found totals of about 266 billion yuan. Extrapolating those figures suggests that ICBC could hold debts of over 13 trillion yuan ($2.05 trillion), and ICBC is just one of several banks involved.

China is well known for intellectual property theft -- one consulting group called it the second most common form of fraud in a country -- and without an official governing body or accounting standards, the finance sector has fallen victim to the same kinds of wholesale lies. Activist investors like Andrew Left and Carson Block have taken the place of regulators, and the two men have called bluffs on a number of Chinese companies. Left precipitated a 17.4% drop in China MediaExpress Holdings after calling the company a "phantom" and saying it was "too good to be true." Last year, as my colleague Dan Newman described, Block published a screed against RINO International, asserting that many of its customers were fictional, which led to a total collapse of the stock and its delisting from Nasdaq.

3. Civil unrestThe Chinese government's draconian land-grab policies have become all too real in places like Wukan, in Southern China. Most rural land in China is nominally owned by village collectives, but officials can seize it by paying a (usually undervalued) fee. The townspeople in Wukan responded to the confiscation of a pig farm by destroying police vehicles and government buildings, and the protest turned into a full-on revolt earlier this month as residents set up blockades to keep the police out and armed themselves with homemade weapons. After negotiations last week, the uprising appears to have come to a resolution.

Even if the Wukan uprising turns out to be an isolated incident, it's still evidence of China's growing pains. The Asian power's transformation into a modern economy and its coming-of-age in the information era make for strange bedfellows with the regime's command economy and media and speech controls. This explosive mix can only last so long. At least one Chinese official, Zhu Mingguo, secretary of the southern Guangdong province, believes the Wukan rebellion is a sign of things to come. "In terms of society, the public's awareness of democracy, equality, and rights is constantly strengthening, and their corresponding demands are growing," he said.

Taming the dragonInvestors seem to have already soured on Chinese stocks. One tracking fund, the iShares FTSE China 25 Index Fund (NYSE: FXI) has dropped about 20% in a year that has been particularly hard on Asian markets. With the risk of the bubble bursting, I'd avoid any companies that are involved in the Chinese financial mess or supplying resources needed for construction. I'm also particularly wary of companies that benefit from government speech controls, such as the group of Chinese equivalents of American Internet services like Baidu (Nasdaq: BIDU) , China's Google; SINA (Nasdaq: SINA) , which owns China's Twitter; or Renren (NYSE: RENN) , China's Facebook. History has shown that regulatory barriers to outside competition are neither good policy nor a sustainable advantage.

Emerging markets continue to provide the most growth for investors, but they come with risks. I still like Starbucks (Nasdaq: SBUX) , Coca-Cola, and Philip Morris in China because they're proven winners that play right into China's newfound love of conspicuous consumption. Even if the bubble pops, a sluggish China should still outgrow a sluggish West. One China bear, Vikram Mansharamani, believes its growth rate will slow to 4% over the next decade, a sharp drop from last decade's 9%-10% but still outpacing the U.S.'s current 1%-2% rate.

China may no longer be the world's hottest growth story, so if you're looking for exposure to a different emerging market, check out this Latin American retailer our experts at the Fool love. In fact, they're calling it their "Top Stock for 2012," and they've published a free report explaining in detail why they think this is such a good buy. The report is yours and it's free. Just click right here.

Comments from our Foolish Readers

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But I too am avoiding China. I've got about 8% of my investments in Asia and Australia via mutual funds, and I've avoided purchasing stocks directly in Chinese companies, so I guess I agree with the author.

Yes, capitalism trumps communism. If you actually believe that China is 'communist'. I don't see many of the proleteriat controlling the means of production over there. If there was, there wouldn't be a Chinese stock market to invest in.

The shanghai index topped out in October 2007 at about 6500, and is now down to 2250...

I think most of what you write has been priced in....

Why is Chinese real estate any different than us real estate...we just have occupied housing, no one wants to foreclose on...ever benn to Arizona?..whole complexes empty..just don't hear about it on news..

Paul Krugman did a column on China's Real Estate Bubble a week or two back. Bloomberg story yesterday reported that December was the 4th consecutive month of housing price decline in China (including drops in all 10 of their top 10 markets). Hard or Soft, the bubble is certainly coming to an end and we are all going to feel it to one extent or another.

I'd love to invest ex-China, but Out of curiousity ... how does one invest and avoid China at the same time (besides shorting). Seems difficult to find a company that doesn't have some exposure to China directly or indirectly. What long companies benefit from a China bubble burst?

They are killing themselves as well, almost no pollution standards. It will be an environmental disaster if they don't implement some decent standards and enforce them. Oh well, we will have the ipads, I guess.

Although I agree with everything you state in this article, I believe you should not be avoiding China for the long-term. Although GDP is a much debated way of defining economic wealth / strength historically China and India had the highest GDP all the way up to the industrial revolution. As shown in: "Contours of the World Economy 1-2030 AD: Essays in Macro-Economic History". Obviously this has to do with the huge population both countries have. So even though they might not be better at anything in particular, they just vastly out number current economic powers in terms of population.

For the long-term history clearly shows China and India will eventually be the economic super powers. If only because of their huge population. Of course short-term you are absolutely right.

UGH....another tail of wo about China. It is apparent the fools hold a short pos. in China. They keep throwing these great articles down our throat.

China is a creature that most Americans don't/can't comprehend. Lets look at some real numbers. For example:

China currency reserves = $2.5 Trillion

US = $70 billion

Chinese Public Debt = 15.6%

US = 40%

Chinese External Debt = $400 Billion

US = $14 Trillion

With these numbers one would have to conclude that the economic growth of the US has been top loaded and on the backs of Debt stricken consumers. IMO the entire US economy is very artificial or a Shill if you will. EBAY great growth, Coca great Growth, Amazon great growth, Ford great growth etc. etc......but all on the backs of a consumer that can't even get his or her head above water. You tell me who is running the bigger illusion. Oh wait U.s economy is slowing.....lets raise the debt ceiling......again. You Fool's have to remember the Chinese can live off rice and fish heads for years. The U.S consumer would go into a nervous breakdown if they couldn't get their $8 Latte and McRib.

$14 trillion dollars of external debt is equal to one year's gross output for the US. No, that's not idea, but if I buy a house, odds are realllllly good I'm going to be in debt for more than one year's worth of my income.

If it really came down to it, the US could just print a bunch more money. We can't run out of US dollars.

More important than the deficit by far is getting the economy running. With interest rates lower than the inflation rate we can almost make money by taking out more debt, making this a prime time to make capital investments in our national economy and getting the economy back on its feet. This isn't very difficult, other than politically.

@FutureMonkey: Great question about what companies benefit from a Chinese bubble bursting. I've been thinking the same thing. Logically, I would think it would be a company competing with China. I think one interesting play is a rare earth miner like Molycorp. China produces nearly all of the world's rare earth metals, and has played games with prices through their export quotas. But its goal is to move the country forward from a manufacturing economy to a high-tech economy, which is why it is limiting the export of those metals used for flat-screen TVs, electric vehicle motors and other 21st century technology. If China's bubble pops, the government may want to double down on this high-tech strategy and restrict exports further.

@tjsimone: I agree that some of my concerns are already priced into the market. They should be. We are witnessing a slow-moving train wreck, not an overnight catastrophe. The Shanghai index is actually up since it bottomed in 2008 though. The drop was mainly from the financial crisis and mirrored a similar, though smaller, drop in American markets. The two markets have really diverged over the last two years as the US has had a moderate recovery and China's market is still declining. The most important difference between our bubble and theirs seems to be in the severity. As I said, real estate prices are 9 times the average income there. At the height of our housing bubble, it was only 5.1. Also, if that 64 million vacant apartments figure is true, that far outnumbers anything the US has ever seen, even by percentage I would think. There are only 110 million households here.

@Darwood11: I think Yum! Brands is still a solid investment. They have more exposure to China than some of the other American companies I named, but there will still be growth there even with a bubble. They could take a hit short-term though.

@Glasscase: Part of my concern with China is that you just can't trust their numbers. If the implications of that Bloomberg article are accurate then just one of those banks is holding $2 trillion in debt. You might as well tack that on to the government's total because this real estate boom is essentially a government program. I agree that the US is no exemplar when it comes to debt control, but that doesn't mean we shouldn't call a spade a spade.

I think your validating my point with the statment the "US could just print more money" . The premis for my post was to simply keep Fools comparing Apples to Apples. I have read example after example of neg. outlook for China.

IMO you can't even compare the US and China without eliminating the 14 trillion in US debt.

Look at GDP Vs. GPI

GDP - measures what is produced, but ignores what is required to create that production. So long as the factory keeps churning stuff out to be flogged to consumers, nothing else matters.

GPI - looks at economic activity from the point of view of the impact it has on the individual and society, not the impact it has on a bank balance.

So the US has better consumer output, better GDP but inorder to achieve this statis it had to go $14 trillion in the hole to do so????

So the US has a faster race car but had to borrow the engine from the Chinese to make the car run.

To compare China and US for giggles lets compare the two using the same debt load numbers - consumer & Gross. Lets factor the GPI numbers as well.

Hypathetical:

It cost the US $4 to make $1 dollar of GDP

It cost China $.33 to make $1 dollar of GDP

Now factor in the idea that the US had to borrow the $4 to make that $1.

I have experience dealing with China. You cannot trust their numbers. There is no way of knowing what is actually happening there. Therefor all the arguments that rely on Chinese data are moot. Foreigners with no family connections to industrial leaders/business owners will not profit from investments in China. Frankly, Chinese promoters do not understand why foreigners would buy shares in Chinese companies because such investors are not protected by family connections. On the other hand these promoters have learned that foreigners will invest so many Chinese firms have got listings on US exchanges in order to get their hands on "free money" knowing that there is no accountability and no mechanisms for redress. Americans are accustomed to the rule of law which protects minority shareholders. There are no such laws in China and no traditions of protecting minority shareholders.

The big international accounting firms do have offices in China but they are just franchises. The real owners and operators of these franchises are local Chinese so any "audited" statements they might produce are also suspect in my opinion.

My mistrust of the business culture in the People's Republic of China does not diminish my enduring respect for the business culture in Taiwan, Hong Kong, Singapore or the large ethnic Chinese communities in the US, Canada, & Britain, etc.

I don't think Motley Fool as a whole is overtly negative on China. Certainly there are many recommendations on the newsletters that are either direct investments in Chinese companies or Companies where China is a large part of the thesis for the companies success.

I think there is still plenty of optimistic business news related to China, but the worm is starting to turn with more and more caution about heavy China focus, particular because of the Real Estate worries. Chinese have been speculating, overbuilding, and over-reaching just like we did. If supply is outstripping demand and price support is based on speculative investment, then at some point somebody is going to be left holding the bag when the music stops and the bubble will burst. I'm sure that China will attempt action to prevent this, but that is no guarantee of a soft landing.

It is easier to figure out what sectors would suffer (raw materials - Australia), consumer imports (AAPL comes to mind), and other companies that depend on China the consumer rather than China the producer.

China's economy is a complex puzzle box and there is no easy way to predict outcome of any one action or trend.

For me I am decreasing exposure to companies with high requirement for China consumption to meet their targets in 2012-2013. I don't own any China based businesses except in broadly diversified ETFs or Mutual Funds.

"I don't think Motley Fool as a whole is overtly negative on China. Certainly there are many recommendations on the newsletters that are either direct investments in Chinese companies or Companies where China is a large part of the thesis for the companies success. "

That's true, I think TMF presents both sides pretty fairly. I was referring more to the average retail investor. It seems pretty common to hear people talk about China as being "one massive fraud", a "ponzi scheme", etc, without really looking at the facts.

Sending report...

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